Pre-Auction Investments by Type-Conscious Agents

34 Pages Posted: 28 Oct 2006

See all articles by Ying Li

Ying Li

Texas A&M University - Department of Information & Operations Management

William S. Lovejoy

University of Michigan, Stephen M. Ross School of Business

Sudheer Gupta

Simon Fraser University

Date Written: September 2006

Abstract

This paper examines pre-auction investments made by asymmetric agents that compete for a supply contract from a monopolist principal. Agents are privately aware of their managerial efficiencies which determine how well they can leverage fixed investments to reduce their variable costs for servicing the contract, and they privately choose investment levels prior to the procurement mechanism being declared by the principal. Hence, the distribution of types that is standard in the principal-agent literature is, here, endogenously determined by the private actions of the agents. The principal declares a mechanism that is optimal for her, after agents have made their private investment decisions. We show that in equilibrium all optimal investment strategies by competing firms will have the form of investing as if there is no reservation price up to a critical level of managerial type, and investing minimally thereafter. This feature, however, implies that only trivial pure strategy equilibria can exist when the principal has any reasonably competitive alternative for servicing the contract. This is because in these cases an optimal mechanism induces agents to adopt a discontinuous investment strategy which provides the principal an incentive to deviate from the declared mechanism. An intuitive extrapolation of the extant literature to our context (in which agents adopt technologies featuring a fixed-variable cost trade-off) would suggest that we would see 'underinvestment', manifesting itself as lower fixed and higher variable cost technologies in the industry. However, this intuition is either sustained trivially or cannot be sustained in pure strategies when the principal has any reasonable outside options for supply. The question of what cost structure we will see in equilibrium in these contexts will require future effort, and a consideration of mixed strategies.

Keywords: Auctions, capacity investments, asymmetric information

JEL Classification: D21, D24, D44, I10

Suggested Citation

Li, Ying and Lovejoy, William S. and Gupta, Sudheer, Pre-Auction Investments by Type-Conscious Agents (September 2006). Ross School of Business Paper No. 1057. Available at SSRN: https://ssrn.com/abstract=940669 or http://dx.doi.org/10.2139/ssrn.940669

Ying Li (Contact Author)

Texas A&M University - Department of Information & Operations Management ( email )

430 Wehner
College Station, TX 77843-4218
United States

William S. Lovejoy

University of Michigan, Stephen M. Ross School of Business ( email )

701 Tappan Street
Ann Arbor, MI MI 48109
United States

Sudheer Gupta

Simon Fraser University ( email )

Burnaby, British Columbia V5A 1S6
Canada

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